How Google AdWords Works [Infographic]

Paying Per Click (PPC), Impression (CPM), and Choosing How Much to Bid

Google AdWords is a genius platform – it gives business owners access to 90% of internet users – but it’s tough to understand what you’re really paying for and why.

The Google AdWords auction model isn’t a revolutionary system, but its application to Google search and display networks makes it an extremely efficient and profitable system that helps businesses control how often they show their ads and how much money they are making from them.

At a high level, AdWords is powered by an auction bidding market. Without getting too deep into the weeds just yet, lets quickly break down those two keywords: auction and bidding.

Think of a live auction – an item is put up for sale with a starting price, and the fast-talking auctioneer begins calling for bids. In Google’s auction, the items up for grabs are the placement of display ads on the display network and search ads for search terms known as “keywords” on Google.com.

The people holding up the paddles to bid are advertisers raising their paddle behalf of products and services.

In this AdWords auction market, advertisers compete to show their ads to potential customers. If you’re following so far, you should wonder: “So if it’s like an auction, the sale goes to the highest bidder, right?”

Not so fast.

This is where AdWords really sets itself apart: How often an ad shows, its position on the page, and how much the ad costs all depend on two factors: the advertiser’s bid AND the projected quality of the ads.

Google.com is the most used internet tool and website in the history of ever! “Googling” did not become a universal verb because Google sold search results to the highest bidder.

Google became Google because they show people exactly what they want to see: quality results that answer questions with reliable information, up-to-date resources, and a wide variety of websites.

Google will not jeopardize their core user base by providing a bad experience, so it incentivizes quality ads by essentially giving a discount to the best ads in the form of a quality score.

If your ads are crap (low quality score), you have to pay a lot more (super high bids) to Google for them to make it worthwhile to show the ad to their users.

Now that we have that fundamental overview, let’s get dive into what Pay-Per-Click advertising is, how the model works, and how you can make money using PPC. There’s a nifty infographic for ya to keep on hand next time you visit AdWords.

What is Pay-per-click (PPC)?

PPC stands for Pay-Per-Click, which is an advertising model Google utilizes where advertisers pay every time a user clicks on the ad.

Using the auction example from before, a person clicking on your ad is the equivalent of the auctioneer yelling “SOLD! To the fellow with the toupee in the back row.”

The PPC model helped once-skeptical businesses adopt the idea of digital advertising in the early days because it presents a lower-risk and more measurable opportunity for advertisers.

The option to bid for impressions was rolled out by Google in 2013 for people advertising on the Display Network. This is known as Cost-Per-Impression bidding, or CPM.

Instead of paying every time someone clicks your ad, you pay every time your ad shows 1,000 times. You can also bid for “Viewable CPM”, which is Google’s standard for making sure the ad is actually seen by the user.

“An ad is counted as “viewable” when 50 percent of your ad shows on screen for one second or longer for display ads and two seconds or longer for video ads. You can select Viewable CPM as a bid strategy when you choose CPM bidding for your “Display Network only” campaign. Source: Google

How Does the AdWords Auction Work?

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Okay, let’s break this down one step at a time.

Whenever someone Googles something, Google’s algorithm checks to see if advertisers are bidding on the major keywords of that search query.

Google starts an auction if the keywords are relevant and identifies which advertisers qualify for the auction. If you thought auctioneers move their lips fast, just wait. In just a fraction of a second, Google takes all the qualifying ads and their respective bids to instantly determine which ads show and in what order on the search results page (SERP).

What Ads Qualify for the Auction?

Advertisers identify groups of keywords to bid on for every ad they create. Google uses that to determine which one is the single most relevant keyword to enter the auction. Ads that have poor relevancy, are unapproved, or irrelevant to the query (like targeting a different country), are not shown.

Google AdWords Auction Factors

According to Google themselves, the 3 main factors that the AdWords auction takes into consideration when determining where to place your ad are Your Bid, The Quality of Your Ads, and the expected impact of your ad.

Your bid is the maximum amount of money you’re willing to pay in order for your ad to show. This is also known as your Max CPC Bid.

The quality of your ads is another way of saying quality score. Not only is it an important factor of the Adwords auction, but there are factors that lie within your quality score that help determine it. They include:

Google’s Expected Click-Through Rate (CTR)

Historical Adwords Performance

The Quality and Relevance of your Keywords

The Quality and Relevance of your Landing Page

The Quality and Relevance of your Ad Text

The last factor is the expected impact of your ad. Part of this was touched on already, as expected CTR is a part of your quality score. Beyond that, AdWords will look at any ad extensions you’ve added, such as call extensions, and determine how that will impact how people interact with your ad.

These can be beneficial because if you’re using highly relevant and accurate ad extensions, your ad might rank higher, even if your competition has a higher Max CPC Bid.

How Are Ads Ranked?

When partaking in the auction process, Google determines your rank by using this formula:

The auction system is set up so that advertisers only need to bid 1 cent higher than the advertiser below them. However, advertisers with a lower bid can rank higher than a higher bidder if they have an ad that has a higher quality score.

If you look at the chart above, “XYZ” brands bid $1 more than PPC Agency, but ranked lower because their quality score was 2 points lower.

Moral of the story: The more time you spend on optimizing your ad and your landing pages, the more money you’ll save!

How Much Do Ads Cost?

As we mentioned before, the auction system is set up so that you pay the minimum amount to retain your ad position, because you only have to pay 1 cent more than the ad placed under you. This is determined by this formula:

Let’s revisit the chart above.

As you can see, fighting for a higher rank fancies the opportunity to save money on your ads. However, it’s important to note that highly competitive keywords effectively increase the overall cost of the keyword for everybody competing for it.

How much should I pay for a click?

It’s important to take a step back from the formulas and think about the basic question: how much am I willing to pay for a click? This is the fundamental question for AdWords success.

Let’s walk through a 1-minute exercise to help you determine your optimal CPC.

Take the product or service you are trying to sell. What is the price?

Understand the cost to produce, ship and sell that product. What are your costs?

Subtracting costs from price gives you your Profit or Profit margin! This is how much money you make from a sale.

Now that we have that profit margin number, we can work backwards to determine how much you should bid for someone to click on your ad.

If you know the conversion rate of your website, you can figure out how many clicks you need to generate one sale.

Let’s use an example of a $150 pair of headphones that cost $50 to make. Your profit on each headphone sale is $100.

If you know that 5% of people who make it to your website buy a pair of headphones (a 5% conversion rate), you make one sale for every 20 people.

If you’re using ads to get those people to your site, you need 20 clicks to generate 1 sale worth $100 for your business. If you divide $100 by 20, you get $5.

This is the maximum amount of money you should pay for a click if you want to run a break-even advertising campaign. This is your maximum cost per click that you are willing to pay. In other words, this is the highest you should set your bids for an advertisement for your headphones.

If our headphone business can generate a CPC below $5, you’re making money off your ads.

The next step is maximizing the amount of money you make from AdWords ads. Using this example, what if we found an audience online or set of keywords that not only cost $0.50 per click, but also convert 50% of the time because your headphone were EXACTLY what they were looking for.

20 clicks at a $5.00 CPC costs you $100 in AdWords spend which cancels out the profit margin of a single headphone sale. 20 clicks at a $0.50 CPC with our 50% conversion rate costs $10 in AdWords spend, which equals 10 sales (conversions) resulting in $990 profit for your headphone business.

Tweaking (or “optimizing”) that audience took your business from break-even, to $990 in the green from just $10 spent on AdWords.

There are victories like this big and small everywhere in AdWords, and that’s what this blog and AdHawk are for: giving you the tools and know-how to find and tackle these opportunities.

Bidding You Farewell

So that’s how the auction system works. If you have any questions, don’t hesitate to drop a comment or tweet at us @AdHawk. I’d be more than happy to answer any questions you have! Until next time.

7 responses to “How Google AdWords Works [Infographic]”

This is a Great Article. But according to the date this article was written I have a doubt on Ad Rank Formula and How CPC is being calculated? Is that right? (I know this was assumed one by professionals, not official from Google). What about Expected Impact from Ad extensions and formats in Ad Rank, did you missed it?